A search for firm characteristics that explain option-granting behaviour in South Africa

Miller, Taryn

A search for firm characteristics that explain option-granting behaviour in South Africa

Master Thesis

2003

Publisher

University of Cape Town

Department

College of Accounting

Faculty

Faculty of Commerce

Abstract

Share options have become a popular, frequently rewarding and incentive-providing form of remuneration for executive directors and other employees. Previous international research has shown that the firm's decision to grant share options may be influenced by its financial reporting situation; its tax position; the existence of conflicting interests between management and other stakeholders; as well as the firm's size and liquidity situation. The reasons why the conflict of interest has been found to be significantly associated with the granting of share options is because share options can align the interests of management with those of the shareholders and in so doing reduce the extent of agency costs. The lack of an accounting requirement to recognise share options as an expense has also been found to influence the firms' decision to grant share options depending on its financial reporting position. The firm's tax position has also been associated with the decision to grant options based on the fact that firms cannot obtain a tax deduction for the value of share options granted. Finally, large firms with liquidity constraints have been found to be more likely to grant share options, due to the lack of available cash reserves for the payment of salaries. There has been no research as to whether the above explanatory variables influence the granting of share options by South African firms. The objective of this study is to investigate whether the variables that were identified internationally as being associated with share option grants apply to grants made to South African executive directors. This study examines whether the extent of share options granted is associated with various financial reporting and tax indicators, proxies for agency costs, the firm's size and its liquidity. Data from 61 firms over 2000 and 2001 was obtained. A total of 33 firms that granted share options were examined together with 28 firms that did not. The value of share options was measured using the dividend-adjusted Black Scholes model, and the dependent variable was calculated to be the value of share options granted during the year divided by the sum of the value of share options granted and the annual cash salary paid to the executives. This variable was regressed against thirteen independent variables identified in previous research. The results of this research indicate strongly that the larger the finn and the greater the extent of future growth opportunities (represented by the ratio of research and development to total assets), the more likely it is that finns will grant options, both of which are consistent with existing theoty. Option granting behaviour was also found to differ across industries and there was some evidence that the more difficult it is to monitor executive's performance (represented by the ratio of the variance in return on equity to the variance in share price), the more likely it is that the finn will grant options. Variables that were statistically significant but in the opposite direction to what was expected were growth in assets and the market-to-book ratio, both of which were negatively correlated with option granting behaviour. TIlls inconsistency may however be due to the fact that the data from the sample may not be a true reflection of the population. Financial reporting incentives, tax disincentives, liquidity, and two proxies for agency costs (the variance of market-adjusted returns and the ratio of the variance of marketadjusted returns to total returns) were not found to be significantly associated with option granting. TIlls suggests that the lack of a requirement to recognise share options as an expense; no deductions of share options for tax purposes; the fact that executive's choose to invest in projects that yield highly variable returns; and that finns that have a large amount of noise in their share price relative to the market, do not influence the decision to grant share options in South Africa. It therefore appears that the key drivers for granting share options to South African executive directors are finn size, unclear signals between earnings performance and the quality of manager's decisions and the desire to reduce agency costs by encouraging managers to focus on long-term investment opportunities.

Description

Includes bibliographical references.

Keywords

Economics

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